Canada: Cross-Border Incentive Plans: One Size Does Not Fit All

To recruit and retain highly skilled and experienced executives,
companies must offer innovative and attractive compensation
packages. Variable compensation is an increasingly important
element of overall remuneration as businesses seek to link
remuneration to performance over both the short and long term.

Businesses with cross-border operations often seek to harmonize
compensation packages for senior level employees where possible. As
a result, it is common for such organizations to have Canadian
employees participate in existing U.S. long-term incentive
plans.

There are, however, several key differences between the tax and
employment laws in the U.S. and Canada (and even differences
between jurisdictions within Canada). These differences mean that
incentive plans drafted to comply with U.S. rules and best
practices may need to be modified for use in Canada to ensure that
the arrangement meets the business objectives on both sides of the
border and does not result in unintended legal consequences. This
white paper will explore some of these differences and highlight
key issues that corporate counsel should consider when utilizing
U.S.-style incentive arrangements for Canadian employees.

DESIGN OPTIONS

Businesses have various objectives for implementing long- term
incentive plans, including linking compensation to performance of
the business over a period longer than one year and encouraging
employee share ownership. A key driver in the design of long-term
incentive plans is the tax treatment of the award for both the
employer and the employee.

In Canada, compensation is typically taxed in the year the
employee receives (or constructively receives) the payment.
However, if an employee is entitled to receive an amount in a
future year and the arrangement meets the definition of a salary
deferral arrangement (SDA), the deferred compensation is taxable in
year one and subsequent increases in value (e.g., where the
original deferred amount increases with share price) are taxable
during the deferral period. As a result, SDAs may result in tax
being payable by an employee and the employer being required to
withhold, remit and report tax before the employee actually
receives payment (or even knows what that payment will be).

Canadian long-term incentive plans are, therefore, typically
designed to fit within one of the exceptions to the SDA definition
or within the stock option rules under the Income Tax Act
(ITA).

STOCK OPTION PLANS

In Canada, a stock option plan is the most tax-efficient long-
term incentive arrangement from an employee perspective, and
U.S.-style stock option plans typically work well for Canadian
employees. Stock options in Canada are generally taxed on exercise,
not on the date of grant, and the "in-the- money" amount
(i.e., the difference between the exercise price and the fair
market value, or FMV, of the shares at the time of exercise) is
included as income for the employee in the year of exercise. On
disposition of shares acquired pursuant to the option, capital
gain/loss treatment will be applied to any increase or decrease in
share value after exercise.

In Canada, the primary tax advantage of granting stock options
is the potential for employees to receive, if certain conditions
are met, a 50 percent tax deduction against the
"in-the-money" amount. This results, effectively, in
capital gains treatment, as only 50 percent of a capital gain is
subject to tax under the ITA. These conditions are quite detailed,
but they generally require the shares to be "prescribed
shares" (essentially plain vanilla common shares not subject
to repurchase by the issuer or a significant shareholder), the
recipient to be arm's length from the company and the option to
have an exercise price not less than FMV on the date of grant.

RESTRICTED STOCK AWARDS

Restricted stock awards (RSAs) are another type of share-based
plan popular in the U.S., in which stock is issued to employees
with certain restrictions (e.g., vesting conditions) and the
employee is not permitted to sell or transfer the stock until the
conditions have been satisfied. If the conditions are not
satisfied, the employee forfeits the stock.

Key differences between RSAs in the U.S. and Canada are:

Timingoftheincomeinclusion: In the U.S., the value of the RSA is
included in income when the conditions have been satisfied (i.e.,
on vesting) unless a section 83(b) election is filed, which
accelerates the recognition of

income to the date of grant. In Canada, the value of the RSA is
always included in income on the date of grant.

Valuation: In the
U.S., utilizing a liquidation valuation (i.e., valuing the award as
if the company were to liquidate its assets) is considered
acceptable and can result, in certain situations, in the RSA having
a nil or very low value on

the date of grant. In Canada, this is not an acceptable
approach, and the FMV of the RSA will likely have some value
(although it should be noted that in Canada, the FMV may take into
consideration the restrictions placed on the stock).

RSAs for Canadian employees may be appropriate in certain
circumstances -- such as if the shares have a very low FMV after
taking into account the impact of the restrictions -- but RSAs are
often not the most tax-efficient way to compensate employees in
Canada, as employees may have adverse tax consequences if they
forfeit the shares.

PROFITS INTEREST

An increasingly common compensation arrangement for U.S.
partnerships and LLCs is to grant a "profits interest" to
senior level employees, which allows them to share in future
profits. In Canada, there is no specific concept of "profits
interest" under the existing tax regime. What this means is
that, in Canada, the details of the particular arrangement must be
assessed to determine whether the "profits interest" is a
grant of security (and can arguably be treated as capital in the
hands of the individual) or a promise of future earnings
distributions (which may be considered employment income). Although
there is no specified regime for profits interests in Canada, if
designed properly, they can be an effective method for compensating
Canadian employees when a U.S. partnership or LLC is involved.

PHANTOM EQUITY PLANS

Although not as tax-efficient for employees in Canada as stock
options, U.S.-style phantom equity plans (e.g., restricted stock
units, or RSUs) generally work fairly well in Canada. Employees are
granted "units," and each unit typically represents one
share of the company. The units then track the share value, and
additional RSUs can be granted to reflect any dividend payments.
RSUs often include time or performance-based vesting conditions and
are settled in either shares or cash. The value of the shares or
cash received by the employee is included in income.

While U.S.-style RSU plans in Canada generally work well, the
main takeaway for employers who use RSUs in Canada is that, if the
RSUs are not required to be settled in shares issued from treasury,
the awards must be settled within three years of the year in which
the grant relates in order to escape taxation under the SDA
rules.

DUAL TAXPAYERS

Another consideration in the design of cross border plans is
whether there are any participants who are both Canadian and U.S.
taxpayers. If so, the company may need to ensure that the plan
complies with rules on both sides of the border and also may be
required to withhold and remit tax to both the Canadian and U.S.
authorities.

SPECIFIC PLAN TERMS

Long-term incentive plans often contain certain definitions, as
well as provisions relating to the vesting of awards on
"termination of employment," restrictive covenants and
clawbacks that give rise to specific issues in the Canadian
context.

DEFINITIONS OF "JUST CAUSE" AND
"DISABILITY"

In Canada, termination of employment for "cause" is
very difficult to prove and is generally determined with reference
to common law principles. Definitions of "disability"
must also reflect certain accommodations and other human rights
obligations relevant to employers in Canada. As a result,
definitions of cause and disability found in U.S. plans may not be
easily transferrable to Canada.

VESTING ON TERMINATION OF EMPLOYMENT

U.S. and Canadian long-term incentive plans often contain
vesting conditions for awards, and the intention of many
organizations is that vesting shall not occur after employment
ends. However, there is no concept of "at will"
employment in Canada, and the employee is generally entitled to
notice of termination under employment standards legislation and
the common law. In this respect, Canadian courts have found that
"termination date" may be interpreted to mean the date on
which employment has "lawfully" terminated (i.e., at the
end of the applicable notice period). Without careful drafting of
the vesting provisions, there may be unintended vesting that
continues after a Canadian participant ceases to provide
services.

RESTRICTIVE COVENANTS

A common design feature that we see in U.S. long-term incentive
plans is the inclusion of restrictive covenants (RCs), such as
post-termination non-competition and non-solicitation covenants.
Incentive plans may also include confidentiality provisions,
intellectual property provisions and other measures to protect a
company's goodwill in the post-termination period, such as
non-disparagement covenants. Without careful drafting with regard
to Canadian employment laws, however, these provisions may turn out
to be little more than ink on paper for Canadian employees.

In general terms, Canadian courts view non-competition covenants
as contrary to public policy and a "restraint of trade."
Such covenants are rendered unenforceable unless the employing
entity can demonstrate that it has legitimate business interests in
need of legal protection that cannot otherwise be protected by less
intrusive means. Further, all RCs must be narrowly drafted with
respect to temporal and geographic scope, as well as the scope of
activities restricted, in order to be enforceable.

For RCs that fail to pass muster in the U.S., many jurisdictions
will simply modify or read down the covenants, but in Canada,
courts do not "blue pencil" provisions. Instead, Canadian
courts will generally find that the RC is unenforceable in its
entirety and sever the entire provision from the plan. Also
noteworthy is that, for employees located in Quebec, if employment
is terminated by the employer without cause, a non-competition
covenant entered into prior to termination of employment will not
be enforced.

CLAWBACKS

In contrast to the Sarbanes-Oxley Act of 2002 and the Dodd-
Frank Wall Street Reform and Consumer Protection Act of 2010, which
require clawbacks from compensation received by U.S. executives in
certain circumstances, there are no statutory requirements in
Canada for employers to have clawback policies. Some (mainly
public) companies do include clawback provisions in their
arrangements, and this is something that many regulators and
shareholder advisory service providers encourage. The terms of
clawback provisions in Canada must be clearly and carefully stated
in the plan documents and properly disclosed to employees to
maximize the likelihood of enforceability under Canadian employment
laws.

CORPORATE GOVERNANCE

No matter the plan's design, long-term incentive
arrangements must be established and administered within a
framework of good corporate governance. Both the terms of the
compensation arrangement and each individual grant need to be
documented appropriately and approved by the granting body's
board of directors (or other party authorized under the terms of
the plan, such as a compensation committee). Good corporate
governance that requires documentation of awards and supports the
valuation used is necessary to help protect both the company and
the employee from scrutiny by tax authorities.

CONCLUSION

Harmonizing long-term incentive plans across the U.S.-Canada
border is often a laudable objective and aims to provide
consistency in compensation for senior-level employees and maximize
administrative efficiencies. However, in order to attain these
objectives and avoid unintended consequences, it is vital to
understand the key differences between the tax and employment law
regimes in the U.S. and Canada. Such an understanding will allow
organizations to effectively implement cross-border arrangements
and appropriately adapt them for use in the Canadian market.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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